(The following is the fourth of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers
only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

My commentary (Lars) is in red bold letters.

Asset allocation cannot produce consistent results when applied to short-term time periods, whether the duration is a single year or an entire decade. The real world evidence of this was revealed in our previous installment. But this conclusion should not surprise anyone. For years, industry pundits have questioned the use of “tactical” – or short-term – asset allocation. Speaking with Morningstar’s Christine Benz in 2010, Jason Zweig, a personal finance columnist for The Wall Street Journal, said, “There are tactical asset allocation mutual funds that have been around for a long, long time. There are also many more that no longer exist because they were closed down, because the people with multimillion dollar budgets and supercomputers, and the world’s best investing software failed at it. So I don’t think that the average investor is likely to succeed at it, and I’m really not persuaded that most professionals will either.”1

Why Long-Term Asset Allocation Might be a Better AlternativeOne of the corollaries of asset allocation is the need to rebalance. This is theoretically most effective when practiced over extremely long time periods. The focus on the long-term is critical because, as 2002 and 2008/2009 attest, there always remains the possibility of a short-term “anomaly.” Mark Lund, author of The Effective Investor and located in Draper, Utah, says, “The secret to making asset allocation work is having structured funds in the portfolio mix, rebalancing, and staying with it for the long run. One must know that there will be years when the market goes down but discipline is what wins the game.”

Establishing a fixed asset allocation with regular rebalancing is said to offer the advantage of systematizing the “buy low/sell high” philosophy that investment gurus have long touted as the secret to attaining a winning investment record. Robert R. Johnson, President and CEO, The American College of Financial Services located in Bryn Mawr, Pennsylvania, says, “Asset allocation is not only a valid concept, it is an essential part of a client’s investment plan. It is the rough guide and as part of an investment policy statement, the contract between an advisor and client. Target asset allocations help the client and advisor navigate rough waters. If, for instance, a client has a target stock/bond mix of 60/40, when equity markets have outperformed bond markets, periodic rebalancing will ensure that an investor’s asset allocation doesn’t vary too much from the target. It provides a discipline of buying the asset class that has underperformed and selling the asset class that has outperformed. Straying too far from the target asset allocation can subject the client to unintended risks.”

Again, as with the short-term hypothesis in Part III of this series, it’s easy to conduct an experiment that tests a similar long-term hypothesis.

The Long-Term TestLike the short-term test, we used the Ibbotson data for annual stock and bond returns from 1926 – 2013. Unlike the short-term test, we’ve kept the mix limited to stocks and bonds. Also unlike the short-term test, we won’t guise this test in a story loosely based on characters from a classic Hollywood movie. This time we’ll go straight to the data.

First, we had to decide upon an appropriate long-term time period. Here, for reasons made obvious in Part V of this series, we picked a 40-year time frame. Next, we determined which stock/bond allocations to use. We went with 10% increments from 100% stocks to 100% bonds, figuring this was the only sure way to include the favorite balances of 70/30, 60/40, 50/50, and 40/60. There were a total of 49 40-year periods. The hypothesis here states there exists some allocation – not either 100% stocks or 100% bonds – that will provide the optimal portfolio mix. Here’s how they charted:

What’s interesting with this graph is that it shows the best allocation is no allocation – just put everything in stocks. Across the board, the 100% stock allocation has the highest high annual return, the highest median annual return, and the highest low return. This suggests, for 40-year time periods – not an unusual time duration for someone saving for retirement – the best returns comes from not using asset allocation.

And before you can say “risk-adjusted returns,” a statistical analysis shows the 100% stock portfolio possesses one of the lowest standard deviations. Only 90/10 (0.90%) and 80/20 (0.88%) have a lower standard deviation than 100% stocks (0.99%). All other asset allocations have standard deviations in excess of 1.00%, with the figuring increasing progressively until you have 100% bonds, which has a standard deviation of 2.34%.

We can conclude, with no rebalancing, a portfolio consisting of 100% stocks both performs better and is nearly as, if not more, reliable than all other stock/bond asset allocations.

So clearly, according to this study you should pay your advisor to buy only stocks.

But this leaves us with a question – What about rebalancing? Does rebalancing improve performance? That’s another hypothesis we can easily test.

The Rebalancing TestIn this test we pick one of the more popular asset allocations – the 60% stock/40% bond mix. Again using the annual data provided by Ibbotson from 1926-2013, this time we rebalanced annually. We used a 5% variance to trigger a rebalancing. In real life, to avoid the “blinker” problem (i.e., excessive trading caused by too small a rebalancing trigger), professionals will often use a larger variance (like 5%) before rebalancing. In our case, if at the end of the year stocks exceeded 65% of the portfolio, we sold down to 60% and put the balance in bonds. Likewise, if at the end of the year bonds exceeded 45% of the portfolio, we sold down to 40% and put the balance in stocks.

Remember, the concept of rebalancing is to “sell high” and “buy low.” The hypothesis would therefore state that, by rebalancing, the buy low-sell high asset class trading would yield a higher return. We ran the numbers with the 60/40 split to test this hypothesis. Here are the results:

40-Year Period Annual Returns for 60% Stock/40% BondAsset Allocation Mix Comparing With and Without Rebalancing

Again, the results of this test will disappoint the asset allocation believer. It turns out an investor who does not rebalance will receive a higher return in all areas compared to an investor who rebalances. Needless to say, if rebalancing a stock/bond asset allocation mix doesn’t beat the results of the static case, then it certainly won’t beat the 100% stock mix. Again, in this variation of the long-term test, asset allocation fails.

Why does rebalancing fail? It appears, because stocks routinely (and to a significantly higher degree) perform better than bonds. That means annual rebalancing has you selling stocks in more years than you’re selling bonds.

So, rebalancing is a scam, and you should just buy stocks.

Analyzing the resultsMore than a half century ago, a group of soon-to-be Nobel Prize winners made a guess. Built on the Capital Asset Pricing Model, The Efficient Frontier, and the primacy of rational markets, it became known as Modern Portfolio Theory. The consequence was asset allocation. We computed the consequences of that guess. We just now compared those consequences to experiment. The consequences disagreed with experiment. Therefore, it – asset allocation – is wrong. It’s that simple. It doesn’t make a difference how beautiful the guess was. It doesn’t make a difference how smart the proponents of asset allocation are, that its creators won a Nobel Prize, or that a lot of really famous – and even successful people – will go to their grave believing in asset allocation. It disagrees with experiment. It’s wrong.

If not short-term, if not long-term, does asset allocation offer any value? Intuitively, it seems as though we’re missing something. The practice of “asset allocation” existed long before Modern Portfolio Theory, portfolio optimization, and high-end computing power. There has to be a reason why it’s been used for so long. It had to have added some value to investors.

Maybe it was the way it was used. Maybe it would be beneficial to review how old-time portfolio managers determined whether to invest in stocks or bonds. Maybe, just maybe, knowing this might be the best way professional (human) advisers will be able to survive the coming Robo-Advisor apocalypse.

We’ll cover this in our next and final installment

This article was written for Fiduciary News, a publication written for “ERISA/401k fiduciary, the individual trustee and the professional fiduciary”. I suspect that many financial advisors and the like also read this blog.

I think it reveals some valuable information, although as studies often do, maybe not exactly the information that the researcher intended – or rather some bonus unintended information can be drawn from the focus of the study….in my opinion.

As I see it, handing the keys to your castle over to someone who’s best interest often lies in performing services for a fee(supposedly in your best interest) is not in your best interest. Generally, fees are paid for services such as management and rebalancing of your “portfolio”.

This study and the article’s author conclude that asset allocation and rebalancing are not effective; I agree.

I suspect that the author and I disagree over the value of his fiduciary services.

In other words, no disrespect is intended for the author, as I am sure he is a smart man, but I think that the person who has the most to gain or lose in a decision, should be the one making it.

This is the third installment in the Self Directed Retirement Questions, Answered.

These are questions I’ve been asked, my answers to those questions, and some commentary.

Question:What is the difference between a Self Directed IRA and a Solo 401k?

Answer:A Self Directed IRA requires a Custodian.Custodians are generally banks and investment houses.These Custodians charge fees to baby sit your money and tell you where you can and cannot invest your savings.An SDIRA is far better than a standard IRA, but it can still have high management fees, hoops to jump through, and limitations in what you can invest in.

A Solo 401k, which is designed for the self employed, enables you to invest in anything that the IRS allows.You become the Custodian; therefore you don’t have any filters on your investments (within the framework of the IRS’s allowed investments).You basically don’t have to ask permission to use your own savings as you see fit.Since it is a 401k, you can also borrow up to 50% of the value, up to $50,000.And again, you don’t have to ask permission or fill out piles of paperwork to take out a loan.You draw up the terms, put the terms in your safe, write a check from your 401k to you, and then just make the monthly payments to your 401k.Because you are making payments to your 401k, the interest is essentially free – you are paying yourself!A Solo 401k also enables you to contribute as the employee and the employer; in other words you can contribute over $50,000 a year to your retirement account – or over $100,000 if your spouse is a partner in the business.This is a BIG deal.

Do you have insider information regarding when Goldman Sachs will pull the carpet from under the U.S. stock market?

Is Janet Yellen your cousin? Does she give you tips?

If your answer is no to all of these questions, then why aren’t you taking this opportunity to divorce yourself from this bubble while it’s still inflated?

It is amazing to me that more people are not taking this amazing opportunity to take profits, and instead are electing to roll the dice on market timing or give the keys to their future to some guy who has no stake in their success.

I know that I should not be surprised, as history seems to repeat itself every 7 to 10 years these days. People have exceedingly short memories and attention spans that can only be measured in milliseconds.

I really don’t want to be that guy who said “I told you so”…or “I tried to tell you”.I get no joy in hearing sob stories about how people waited too long and got wiped out by the debt tsunami.

The current market value has no basis in reality.When it goes pop, it is going to destroy the retirement of millions of Americans who blindly followed the pundits on CNBC.

Please, Americans, spend more time thinking about your future and less time getting re-educated by mass media.

This month’s edition of the Most Important Number Ever is out, and the headlines look good. The Bureau of Labor Statistics’ Employment Situation Report, commonly referred to as Non-Farm Payrolls, showed that a total of 163,000 jobs were added to the economy in July. While the headline looks great, there are some issues under the surface as the unemployment rate ticked up to 8.3% and total jobs added for June was revised from 80,000 down to 64,000.

The stock market seems to love the report, but Dan North, chief economist at Euler Hermes cautions against breaking out the party hats just yet. “We need 200,000 or 250,000 jobs a month to start bringing the unemployment rate down,” North says. “These numbers peaked last January, and it’s been a trend downward ever since.”

It’s the worst-kept secret in the financial world that bad news is good for the stock market this year. The darker the picture, the more likely it is that the Federal Reserve will come to the rescue — or at least prop up asset prices — with another round of quantitative easing. If the data aren’t good enough to mark an improvement, stock market participants would just as soon see numbers bad enough to justify Fed intervention.

North says Bernanke already started signalling QE3 with Wednesday’s FOMC statement on rates and will hint even more brazenly at the central bank’s annual gathering in Jackson Hole at the end of the month. Assuming the numbers remain grim, North thinks Bernanke is going to finally launch the endlessly discussed easing program at Fed’s regular meeting on September 13.

“Why would I wait?” says North, putting himself in Bernanke’s shoes. The economy is getting worse. Any actions will take the better part of a year to have an impact, and any hopes for a fiscal policy are going to have to wait until sometime in 2013. The answer to North’s rhetorical question is, obviously, Bernanke would wait because there’s a Presidential election less than two months after the September meeting. Any action by the Fed so close to November would likely hand the election to the President.

Dismissing out of hand the notion that the Fed is apolitical, North notes that Bernanke’s term ends in January, at which point he’ll either be re-appointed or out of work. “Certainly Bernanke will want to have made a positive move if he believes Obama’s going to be President again.”

Economically speaking, North is right in that QE3 is unlikely to succeed where QE’s 1 and 2 failed. In terms of stocks, history would suggest just the opposite.

Earlier this week, I was interviewed by the Council on Foreign Relations(CFR) for its website, about the current state of the Chinese economy.

Silver Linings in China’s Slowdown

China’s gross domestic product for the second quarter declined to 7.6%in July, its lowest level since the height of the global financial crisis in 2009. At the same time, the International Monetary Fund reduced its 2012 growth forecast for China by 0.2 percentage points to 8%. While China has been adversely affected by external factors like the eurozone crisis, its current slowdown is mainly the result of internal structural issues, including a suppression of domestic consumption, says Tsinghua University’s Patrick Chovanec.

“The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis,” explains Chovanec, “and this investment boom is buckling under its own weight.”

What are the main causes-internal and external-of China’s worsening economic slowdown?

A lot of people compare this slowdown to what happened in late 2008, early 2009. The main difference is that what happened in 2008 was primarily due to external causes- a fall-off in exports caused by the economic crisis in the United States. What’s happening now in China is mainly due to internal reasons. The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis, the last slowdown, and this investment boom is buckling under its own weight. It’s not sustainable, and it has given rise to inflation and now to bad debt, and that bad debt is dragging down Chinese growth. And, of course, people pay attention to whether Chinese exports are rising or falling. It’s relevant because if Chinese exports are very vibrant, that creates something of a cushion for the Chinese economy.

If the causes of the slowdown are more internal, and not just a response to outside factors like the eurozone crisis, should we expect a more long-term slowdown?

It really depends on what the Chinese leadership chooses to do. China is due for a correction. That correction will be good for China in the sense that a lot of the growth we’ve been seeing over the past several years is not sustainable and in many ways does more harm than good. So in some ways, slower growth, if it’s part of an adjustment toward a more sustainable growth path, is actually good. That doesn’t mean it’s painless, so there is a lot of resistance, even though in principle China’s leaders know that China needs to make this economic adjustment away from dependence on exports and investment-driven growth toward more domestic consumption-driven growth. If they resist a meaningful adjustment and if they try to pump up the economy even more- try to push this growth model to its limits and beyond- then the repercussions could be more damaging and painful than embracing any economic adjustment, painful as that might be.

I would add that there are lots of areas of potential growth in the Chinese economy- in agriculture, in services, in healthcare, in retail, in logistics. The problem is that that growth is not as easily achieved as pumping money and boosting investment. Unfortunately, that more sustainable growth is not where the focus has been these past few years. But there is nothing to say that the Chinese economy has to be doomed to slow growth.

What are some policy responses China should take to boost domestic consumption and diversify sources of growth?

They have to realize that it is a structural issue. Part of China’s export-led growth model was to suppress consumption in order to maximize investment and then make up the difference through selling abroad. The Chinese economy is geared toward channeling resources away from the household sector- Chinese savers and consumers- toward investors and producers to boost production and basically turbo-charge GDP growth. To re-balance the Chinese economy, you have to channel those resources back to the household sector through changing exchange rate policy, interest rate policy, the tax policy.

The problem is that if you channel resources back to the household sector, you knock the legs out from under the growth that you’ve got, and nobody wants to do that. That’s the biggest challenge- that these are deep reforms that change the way the Chinese economy works, and it takes some foresight and some vision to pursue that.

What of the short-term measures the Chinese central bank has taken by cutting interest rates twice since the beginning of June? Should we expect further measures along this line?

Unfortunately, the short-term response we have seen is to fixate on GDP growth. Even though they talk about the need for quality GDP growth over quantity, whenever GDP starts to look like it’s falling- even slightly- the immediate response is, “We have to shore it up.” The easiest way to shore it up is through more lending, more investment. You get a situation where any movement toward meaningful reform or meaningful re-balancing is put on a shelf. A lot of people have been critical of the efforts to re-stimulate the Chinese economy for precisely that reason. There is a broader recognition that what the Chinese economy needs is not more stimulus, but reform. I don’t think there is a full appreciation for just how constrained the Chinese government really is, even if it chooses to go down that path of re-stimulating the economy. They are actually quite limited in their ability, in the tools they have available to continue pushing down this path.

The conventional view is that China has a debt-to-GDP ratio of about 30% and that it has all kinds of resources to throw at boosting growth. I would draw a comparison to Japan in 1990. Japan had many of the same qualities that would lead you to think it could stimulate its way out of any dilemma. Japan had a high savings rate, almost no foreign debt, and it had a strong fiscal position because of all the taxes raised during the boom of the 1980s. But when the Japanese turned on the fiscal tap, the money went primarily to socialized losses and to counteract a contraction in private investment. The Japanese were able to prevent GDP from collapsing, but they were not able to sustain high levels of GDP growth in the 1990s; the fiscal resources that Japan had went to fill a hole, to pay for the growth of the 1980s.

With the lending boom that took place in China in the last three or four years, it was fiscal spending in disguise, and now the bill is coming due. Once the fiscal taps are open, the money released will go to pay for the growth of the past four years, not the next quarter, not the next year, not the next decade. You start to see that already, with the bailouts starting to take place in China; local governments, even the national government, devoting resources to bailing out property developers, bailing out state-owned enterprises, bailing out companies that have run into trouble, bailing out local governments.

What are the implications of the economic slowdown for the Chinese political situation, particularly given a once-a-decade leadership transition this year?

There’s been little political capital for anyone to spend on meaningful reform or any kind of resolute action on the economy, because if people did have political capital to spend, it was going to be devoted to ensuring their seat at the [leadership] table. What happens after the leadership transition [is] hard to say. The slowdown we are seeing, and particularly the pressures that it has created in the financial system and the credit system in China- the danger of default and the danger of a domino effect rippling through the Chinese economy- has pressed some difficult choices on [the] leadership at a point where they are least prepared to make decisions. The economic situation is not waiting for the leadership transition to work itself out before demanding some kind of response.

What are the potential repercussions of China’s economic situation on the U.S. and global economies?

It depends where you sit relative to the Chinese economy. There are countries and companies that have been riding this investment boom that has been driving Chinese growth, but I would argue that is not sustainable and is now collapsing under its own weight. And for those countries- like Australia selling iron ore, Chile selling copper, Brazil selling iron ore, Germany selling machinery- they’re very exposed to this economic adjustment that’s taking place, this correction.

But if your goal over the long-term is to sell to the Chinese consumer, and if you have an economy positioned to do that- if you’re a producer of finished goods or a producer of food- then this economic adjustment could be a good thing if it unlocks the buying power of the Chinese consumer. For any economy around the world that wants to sell more to China, that wants to have a more balanced trade relationship with China, a meaningful economic adjustment that resulted in a more balanced domestic economy in China would be a very positive thing.

If you have lower GDP in China, that doesn’t necessarily mean that China’s consumption has to fall. In fact, China has $3 trillion in reserve; that’s buying power. China has produced more than it has consumed for many years; China could afford to consume more than it produced. That would be a major growth driver for the rest of the world. It would provide a cushion for China to undertake this kind of economic adjustment that otherwise could be extremely painful.